Should You Pay Off Debt or Invest? A Guide to Help You Prioritize

Sitting on a mountain of debt can be both crippling and costly — especially if it’s high-interest debt. 

But while having debt isn’t fun, put off investing just because you have debt could also be costly to your future. 

It can be tricky to decide if you should first pay off debt or invest, and there is no one-size-fits-all solution. Plus, paying off debt and investing aren’t mutually exclusive — you may be able to do both at the same time. 

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Paying Down Debt vs. Investing

Before you decide which to pursue first, take a close look at your finances. After all, you can’t decide where to put your money if you don’t already know where your money is going!

Your first step is to create a budget. This allows you to get a clearer understanding of your spending habits and your income. It also paints a better picture of where you can make cuts to free up extra cash for spending — or in this case, for paying debt or investing.

Once you’ve made your budget and know how much cash you have to work with, you can now begin to prioritize paying down debt or investing. 

When prioritizing, consider factors like:

• The interest you are paying on the debt versus the interest you could earn on the investment
• The amount of debt you have and whether it’s risking long-term financial damage, like declaring bankruptcy 
• The term length of the debt and how long it could hold you back from investing (for example, a mortgage counts as debt, but can be for up to 30 years — you don’t want to wait 30 years to start investing!)

You should also establish an emergency fund, or sinking fund. This is a pool of money that you set aside in case of an unexpected expense. This prevents you from going into more debt to cover these expenses. 

A high-yield savings account is a good place to put your emergency fund. You can earn interest on the money you deposit, growing the fund faster. (This is actually a form of investing — so by doing this, you’re already on your way!) 

COMPARE: Best High-Yield Savings Accounts

When You Should Pay Off Debt First

First and foremost, if you have debt, know you are not alone. Over 77% of people have debt, according to the October 2023 report from the Federal Reserve. So, while it may sometimes feel like you are isolated on your own little remote debt island, know you most definitely aren’t alone.

Now that that’s out there, know that paying off debt is almost always a solid financial decision. It frees up your cash flow, allowing you to put your money towards other financial goals. Paying off your debt also increases your “net worth,” a fancy finance term for the value of your assets minus your debts (liabilities). 

Paying off debt also saves you money. This is because you pay interest (and sometimes even fees) to maintain the debt. So, instead of giving lenders and credit card companies your money, paying off debt means giving it back to yourself!

Here are some scenarios where it’s better to pay off debt first.

Pay off debt if you have high-interest credit card debt

Credit cards notoriously have some of the highest interest rates of all debts. 

The average annual percentage rate (APR) on credit cards is around 23%, according to the Federal Reserve. Interest rates this high are costly if you carry a balance on your credit card month to month.

Let's use an example of a credit card with a $4,000 balance, a 25% APR, and a minimum monthly payment of 3% of the balance. 

(Keep in mind that APR is the annual rate, so 25% doesn’t mean you pay 25% interest each month, but for the full year — so, roughly 2.1% each month, which is 25% divided by 12 months.)

First minimum payment: $4,000 x 3% = $120

But don’t forget that interest will keep piling up, so you’ll then be charged 2.1% on your new balance.

New balance: $4,000 – $120 = $3,880

Interest owed on new balance: $3,880 x 2.1% = $81.48

New balance with interest: $3,880 + $81.48 = $3,961.48

So, with your $120 payment, you only reduced your balance by less than $40. 

As you can probably see, if you are only making the minimum payments, it’s going to take you years to pay off that $4,000 balance. 

Not only that, but you are spending hundreds of dollars just in interest. Because the interest also piles onto the interest accrued on the original balance, you will technically be making interest payments on the interest.

In this case, it’s wise to get yourself out of credit card debt before focusing on investing. You will spend more money on the interest payments on credit card debt than you will likely earn on investments in the same time frame.

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Pay off debt if you have private student loans

Erika says that she prioritized paying off her $200,000+ in student loans after law school. Yes, even before going for her other money goals, including investing!

The burden of student loan debt is a massive one, especially for Millennials and Gen Zs. According to the Education Data Initiative, 34% of people aged 18-29 and 22% of people aged 30-44 report having student loan debt. 

Like high-interest credit card debt, student debt can be just as debilitating. And depending on the type of loan (federal or private), interest rates can range widely, from 4.5% to 17.99%. So, you can see how impactful it can be to eliminate your student loans, especially if you have private loans.

Private loans tend to have higher rates and different terms. They also aren’t included in any federally sponsored programs or eligible for forgiveness under these programs.

If you need help brainstorming methods to tackle this debt, this calculator from Unbury.me can help you get a visual overview of your loan balances, rates, and payments.

READ MORE: How To Refinance Student Loans

Pay off debt if you need to improve your credit score

Another scenario (that may not even cross your mind) is to consider paying down debt first if your credit score could use some improvement. 

If you have many open accounts with high credit utilization ratios (for example, maxed-out credit cards), this could be hurting your score. 

Credit utilization is a big piece of the credit score puzzle, with a weight of 20% to 30% depending on the credit model. Lowering your utilization can boost your score — plus, it comes with eliminating your debt. I call this a financial “buy one, get one.” 

And if you want to borrow in the future (like taking out a mortgage), your credit score is critical. So, it’s probably best to have a good credit foundation before channeling your energy into investing. 

READ MORE: How To Increase Your Credit Score the Right Way

When You Should Invest First

While having debt can be stressful and costly, there is also a cost in waiting to invest. 

The earlier you start, the longer you will have to grow your investments and build wealth. You also will have a greater risk tolerance with more time to recover any potential losses.

As the old saying goes, “Time in the market beats timing the market.” 

A big pro of investing is that you can earn more than what you originally paid for the asset (also known as a positive “return on investment”). 

Here are some times when you may want to have a higher focus on investing, even if you’re still carrying a bit of debt.

Invest if your debt has low interest rates

If the return on your investment earns you more money than your debt costs you, investing some of your spare cash may make sense.

A good rule of thumb is the 7% rule. 

“If your interest rate is higher than 7%, it's probably better to pay off the debt first,” says Erika. “If your interest rate is lower than 7%, it’s probably better to do both at the same time. Invest while paying off debt.” 

Erika says this because the average market return is between 7% and 10% annually.

Stocks can be volatile though, so it’s important to keep an eye on your portfolio’s performance. 

READ MORE: How To Start Investing

Invest if your employer offers a 401(k) match

No one wants to retire with a mountain of debt, as it is hard enough already to live on a fixed income. So, it’s best to chip away at your debt before you enter your golden years.

However, it’s still a good idea to invest in your retirement, even if you have some debt. This is especially the case if your employer offers a 401(k), specifically with an employer match. 

A 401(k) match is typically offered in the form of a percentage of your contributions and salary. For example, your employer may offer a 50% match up to 6% of your salary. This is free money, so take advantage! 

Plus, interest will compound on your match, equaling more money.

Remember to check your employer’s vesting schedules (or when all of the contributions officially belong to you). 

Invest if you want to take advantage of tax benefits

Certain investment accounts (like IRAs and 401(k)s) can be tax-deferred, meaning you pay taxes later, at a different tax rate. These tax savings can be huge, making it worthwhile to invest now, even if you still have debt.

There are also some tax advantages to certain long-term debts. You can deduct things like mortgage interest and student loan interest on your taxes. These deductions lower your taxable income and can help you cut some tax breaks. 

I’m not recommending you willingly hold onto debts, but it’s something to keep in mind if all other boxes are checked and you’re looking for ways to lessen your payments to Uncle Sam.

FAQs

Why is it important to eliminate debt as soon as possible?

The interest you pay on the debt, as well as fees associated with maintaining it, can really pile up. This causes you to spend more than you originally borrowed — the longer you put off eliminating the debt, the more you will spend. 

Which debt should I pay off first?

This depends on your unique situation. Some may find it easier to use the debt snowball method, which is when you focus on paying your lower balances with smaller payments first. 

Others may find it easier to use the avalanche approach, which is when you prioritize higher-interest debts first. 

If you want to get into investing as soon as possible, I suggest you go for eliminating the higher-interest debts (like credit cards) first. 

What investments are best if you don’t have a lot of money?

It’s best to start with a retirement account, like an IRA or your employer-sponsored 401(k), if you don’t have a lot of money. 

You can also consider investing in fractional shares of individual stocks or in exchange-traded funds (ETFs), which are a collection of stocks and bonds and easy for beginners who want to diversify.

TL;DR

Investing and paying down debt are not mutually exclusive. Depending on the type of debt you have, your best plan may be to do both at the same time.

In general, it’s best to focus on attacking high-interest credit card and student loan debt before investing. You also want to ensure you have a decent foundation for your credit score.

Consider investing if your debt has interest rates under 7% or if your employer offers any plan benefits like a 401(k) match.

For more debt and investing advice, check out these episodes of the Erika Taught Me podcast:

• How To Budget for Beginners
• How To Invest for Beginners (Step by Step)
• 10 Steps Towards Financial Wholeness

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